Do a bit of number-crunching to arrive at the right decision
RISING interest rates are always associated with expensive loans and an overburdened borrower. But this is just one side of the coin. The other side of the coin reflects the rising deposit rates, which have added some zing to this safe investment instrument. The bank fixed deposit rates (FDs) have increased in the range of 0.25-1.5% across tenors. So is this the time to book fresh deposits or break your old one to benefit from the new rates?
Should You Keep Your Old FD?
There is no single answer to this question. Investors should consider the time left before the date of maturity of their FDs before breaking the FD. For instance, if the FD is nearing maturity, it may not be a prudent decision to opt for a premature withdrawal. You will lose some interest income on that deposit, since the interest rate is calculated on an annualised basis. The loss in the interest income may offset the gain you earn from higher deposit rates.
If you had invested around four months back for one year at 7.5% and the rate for one-year deposits has gone up to 8%, then on breaking the previous one, the rate applicable for four months, which maybe 5.5% will be applied. So, there is a loss of 2% on annualised interest or 0.66% for the period.
The second factor to keep in mind is the penalty on premature withdrawals. "If the higher rates are able to compensate the penalties or lower rate for the tenure you have invested for, you could switch. If the rates have gone up by 0.5% and if the premature withdrawal penalty is also 0.5%, then there is no point exiting at this stage.
Most banks charge a penalty of around 1-2% on premature withdrawal of fixed deposits. But if a customer has to withdraw before the actual maturity date, the bank may waive off the penalty. For example, SBI levies a penalty of 1% below the rate applicable for the period of time the deposit remains with the bank. But no bank has a defined list of emergencies under which a customer can be spared from the premature withdrawal penalty. But banks have waived off this penalty for certain unexpected financial emergencies such as illness, death of a family member etc. But this waiver happens on a case-to-case basis and the customer has to convince the bank about the nature of his emergency.
Bank FD vs Company FD
Most of the company FDs still offer a higher interest rate compared to that of bank FDs but one should also consider the financial soundness of the company. The safety and return on company deposits depend on the rating. Usually higher the rating, lower is the return. Typically the return on an AAA-rated company comes very close to that of a bank deposit as the investor is assured of the company's financial soundness. At times, public sector banks offer higher returns than company deposits. For example, the rate offered by LIC Housing Finance on a one-year deposit is 7.6%. It is rated FAAA by Crisil, which indicates the highest degree of safety regarding payment of interest and principal. For the same period, SBI is offering 7.75%. Now this rate is comparable because the company has been given a safe rating. Also, in most of the cases, it takes a longer time to get the credit in case you want to break your company FD before its due maturity. But at today's FD rates, there is not much of a difference, feel financial advisors.
Also, banks typically give a 0.25%-0.5% more for senior citizens. Hence, it could be a good idea to consider bank FDs themselves at this point of time," Sadagopan adds. Bank deposits up to . 1 lakh are covered under the Deposit Insurance and Credit Guarantee Corporation (DICGC), which adds to the safety blanket. However, there is no protection for depositors if a company is in financial trouble as FDs are a part of a company's unsecured debt. A company's non-convertible debenture is a safer bet than a company FD, as it comprises a part of se-cured debt. Company FDs have traditionally offered higher interest rates than those of banks. Companies come out with deposit schemes whenever they require cash to fund their business activities. If these companies are highly cash-strapped, then they will offer even higher rates to woo the public money. One of the biggest risks associated with company deposit rates is the default risk.
Even if the company has a fair reputation in the market, it may not be in a position to pay off your money and interest on time. This is because they tend to invest the money (you park in form of deposits) for specific use, which carries a higher default risk. Unlike, banks which lend your money to several borrowers and companies, the risk is diversified. So, the impact is lesser.
Hence, in case of company FDs, you have to see if it has been rated by any agency like Crisil, Icra etc. Then, one can look at the number of years in business, profitability of the company, the reputation of the promoters etc. If you know of people who invest in FDs, try to find out if they are prompt in sending the maturity proceeds, interest cheques, and how responsive they are.
How to Calculate Your Actual Return?
Banks are offering 8.6% on one-year deposits. This could be higher depending upon the com-pounding effect. If a bank compounds the interest on a quarterly basis, the actually rate would be higher at around 8.8%. More the number of times a bank compounds the interest, higher is the interest income. But that is not the ultimate realisable return you earn on the deposit. Given that the interest income on bank deposits is fully taxable, the net yield is much lower. If a person is in the highest tax bracket, then the actual return after tax of 30.9% is 5.6%. It will be commensurately higher for those in the lower income slabs. Income from FD is fully taxable as income. Also, bank FDs tend to yield relatively lower interest (in view of their lower risk profile).
Bank FDs offer assured returns but they are taxable at a slab rate which may go up to 30.9% for individuals under the highest tax bracket. An investor whose income is above 8 lakh will get the net yield of 5.528% if the FD offers an interest rate of 8% per annum. For instance, if you fall in the 30% tax bracket (income above 8 lakh in the current financial year), your tax liability will be 1,236. Now, if you invest 50,000 and get 54,000 on maturity with 8% interest, the net yield will actually be 5.528.
FDs Can't Beat Inflation: Inflation, as an economic indicator, reflects the value of money over a period of time. Inflation has the ability to erode the value of your investments even as you may have earned some return on them. Whenever you invest in an instrument, compute the future value after accounting for inflation of 8-10% to get accurate results. Let us assume you invested 1,000 in a one-year fixed deposit at 7%. The value of the deposit will be 1,070. But if the inflation has been 8% of the year, the value of 1,000 decreases by 80. The net value of your money is 990 only. So, the net gain after computing the loss of value due to inflation is actually negative. Bank FDs are an essential ingredient in everyone's investment kitty.
They act as a good balance in a portfolio. Low risk-free avenues such as bank deposits and small savings have gained prominence due to vagaries of risky instruments linked to equity market. But FDs alone cannot grow the size of your portfolio. Hence, FDs should just be a small component of your investment portfolio. It should be around 15% for an investor at the start of the career or nearing 30s, 25% for an investor at 40, about 35% for an investor nearing retirement, (another 25% could be in other debt instruments like PPF, debt funds, FMPs etc.).
Think before you act:
Here are some things that you should keep in mind before deciding to break your old FD
Ø Don't exit your old FD if it is nearing maturity. The interest you lose on your existing FD may be more than the new FD rate
Ø You will lose some interest income on the old FD since the interest rate is calculated on an annualised basis Most banks charge a penalty of around 1-2% on premature withdrawal of fixed deposits
Ø Banks can waive off this penalty for certain unexpected financial emergencies including illness and death of a family member But the penalty is waived only on a case-to-case basis and the customer has to convince the bank about the nature of his emergency
